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IBM’s Cognitive Solutions Sales Slumped. What Happened?

Timothy Green, The Motley Fool

A key component of International Business Machines' (NYSE: IBM) turnaround effort is cognitive computing, which encompasses artificial intelligence (AI) along with related technologies. Watson, IBM's cognitive computing system than debuted by winning a game of Jeopardy! in 2011, has been applied to fields including healthcare, financial services, and even Fantasy Football.

Cognitive computing is a growth business for IBM, but you wouldn't know it looking at the company's third-quarter results. The cognitive solutions segment suffered a 5% revenue decline, even after adjusting for a currency-related headwind. That sounds like terrible news for a company betting its future on AI.

The cognitive solutions segment should really be called the "cognitive solutions plus a bunch of other unrelated stuff" segment. It includes Watson and other businesses with growth potential, but also stuff like legacy transaction-processing software. It's kind of a grab bag of IBM businesses that don't quite fit into its other segments.

That makes it difficult to tell how well IBM's growth businesses are really doing, and it makes that 5% sales decline much less meaningful.

The IBM Watson logo.

The IBM Watson logo. Image source: IBM.

Explaining the decline

CFO James Kavanaugh went into some detail during the earnings call regarding the performance of the cognitive solutions business. The segment is broken into two components: solutions software and transaction processing software.

Solutions software includes software aimed at strategic verticals (Kavanaugh singled out the healthcare industry). It also includes some analytics and security offerings, AI like Watson, and blockchain. On top of all that, "horizontal domains" like collaboration and commerce are also included.

Transaction processing software includes "software that runs mission-critical workloads leveraging our hardware platform," according to Kavanaugh. This is mostly on-premises software used by industries like banking, airlines, and retail.

Transaction processing software accounted for a minority of cognitive solutions sales in the third quarter, but revenue from that category declined by 8% year over year. Kavanaugh pointed out that, while most of the revenue for transaction processing software is annuity-based, the timing of large deals can affect sales. Kavanaugh expects a return to growth, based on a strong pipeline of deals.

The solutions software portion of the segment suffered a 3% sales decline, driven by some areas where IBM is struggling. Secular shifts in the collaboration, commerce, and talent management markets are causing problems for the company, and it's been adding AI and modernizing its offerings to combat those changes. The shift to software as a service is also putting pressure on sales, with revenue being realized over time rather than up front.

The parts of this segment with long-term growth potential are the parts that are growing. Watson Health, the company's effort to apply AI to the healthcare industry, enjoyed broad-based growth during the third quarter. Security grew thanks to the company's vast portfolio of products. And the company made some big moves in the blockchain market.

IBM announced TradeLens, a blockchain-based platform for the global shipping industry, in August. The solution, jointly developed with Maersk, had 94 participants on board at the time of the announcement. IBM Food Trust, a new blockchain-based platform that allows food to be traced from farm to store, counts Walmart and French supermarket chain Carrefour as members. IBM's blockchain efforts are still in their infancy, but both of those platforms have the potential to become meaningful businesses for the company.

With the cognitive solutions segment being dragged down by legacy businesses, the headline performance doesn't reflect the performance of IBM's more promising businesses.

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Timothy Green owns shares of IBM. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.